October 13, 2021
Texas adopts amendments to its franchise tax rule for research and development activities credits
On October 4, 2021, the Texas Comptroller of Public Accounts (TX Comptroller) filed with the Secretary of State the final amendments to its franchise tax rule, 34 Tex. Admin. Code Section 3.599 (Section 3.599), regarding the tax credit for research and development (R&D) activities. The final rule will be published in the Texas Register on October 15, 2021. The amendments will be effective retroactively for Texas franchise tax reports originally due on or after January 1, 2014, according to the Preamble to Section 3.599 (Preamble). The TX Comptroller rejected a public comment suggesting that the amended rule only be applied prospectively.1
The TX Comptroller has also adopted amendments to the R&D exemption under its sales and use tax rule, 34 Tex. Admin. Code Section 3.340. This Alert does not address the changes to the R&D exemption under the Texas sales tax law.
Based on public comments, the TX Comptroller changed the proposed text for both rules published in the Texas Register on April 16, 2021 (see Tax Alert 2021-0955).2
The adopted amendments to the franchise tax rule make significant changes to Section 3.599, including:
According to the Preamble, new Section 3.599(c) "discusses the application of the Four-Part Test to explain the basic requirement for research activities to be qualified research" and is based primarily on the federal R&D rules set out in IRC Section 41(d) and Treas. Reg. Section 1.41-4. The Four-Part Test for Texas franchise tax R&D credit purposes, however, differs from these federal rules when applying two parts of the test: (1) the Business Component Test and (2) the Process of Experimentation Test.
The amended Business Component Test explicitly states that a business component does not include a service provided to a customer or a design.3 The TX Comptroller declined to change the rule in response to public comments suggesting that such services and design should be allowed as a business component and requesting removal of subsections 3.599(c)(1)(C)(i) and (ii).
The amended Process of Experimentation Test specifically identifies "non-experimental methods" (including simple trial and error) and describes factors the TX Comptroller may consider in determining whether a trial-and-error method is experimental or non-experimental.4 The TX Comptroller declined to follow public comments suggesting that it eliminate subsection 3.599(c)(1)(D)(vi), which describes such factors, but modified this subsection to address public concerns. The proposed amendment included a non-exhaustive list of "factors considered" in determining whether a trial-and-error method is experimental or non-experimental. The final rule (1) includes a non-exhaustive list of factors that "may be considered" in making such a determination, (2) does not require each enumerated factor to be satisfied, (3) only applies the factors in determining whether a process of experimentation is systematic trial and error, and (4) notes that systematic trial and error is not the only process of experimentation.
The TX Comptroller modified Examples 6, 85 and 96 on the Process of Experimentation Test in Section 3.599(c)(1)(D)(vii)(VI) to address concerns raised in public comments. For example, commentators had raised concerns with Example 6 because it "could be read such that computer-aided simulation would not qualify as a process of experimentation." The TX Comptroller said this was not the intent of the example as Treasury Regulations expressly allow such activities. Regardless, the example was modified to make clear that "in some cases computer-aided simulation and modeling may be experimental process."
Rules of applicability
In describing the application of the Four-Part Test, the final rule adds non-exclusive lists of software development activities that are both likely and unlikely to constitute qualified research.7 The TX Comptroller declined to accept suggestions in the public comments that the Comptroller modify or eliminate this subsection.
Excluded research activities
Section 3.599(d) lists activities that do not constitute qualified research activities. According to the Preamble, this list is based on IRC Section 41(d)(4) and Treas. Reg. Sections 1.41-4(c) and 1.41-4A(d) (specifically related to the funded research exclusion).
Excluded activities as described in the final rule include:
These excluded activities are similar to those provided under the federal R&D rules except for internal use software. The final rule defines internal use software as computer software developed for use in the operation of the business, rather than basing the definition on the federal regulations. Under the definition in the Texas rule, internal use software does not include software that is developed to be commercially sold, leased, licensed or otherwise marketed for separately stated consideration to third parties.8
The final rule on the exclusion from qualified research for funded research states that "a taxable entity performing research for another person must identify any other person paying for the research activities and any person with substantial rights to the results of the research."9
The final rule includes examples.
Credit eligibility requirements
Section 3.599(e) discusses the eligibility requirements for the credit. The final rule adds a provision explaining that the taxable entity has the burden of establishing its entitlement to, and the value of, the credit by clear and convincing evidence. The final rule further requires (1) all qualified research expenses to be paid or incurred in connection with qualified research activities; and (2) all qualified research expenses to be supported by contemporaneous business records. The final rule describes what will constitute contemporaneous business records for wages, supplies and contract research expenses. The TX Comptroller declined to accept a public comment suggesting that it apply the same burden of proof and contemporaneous documentation required for the federal R&D credit, noting that the standards and requirements adopted in the final rule generally apply to all Texas franchise tax credits.
The final rule also specifies that an IRS audit determination of eligibility for the federal research credit is not binding on the TX Comptroller's determination of eligibility for the R&D credit for Texas franchise tax purposes.10
The final rule expands the provisions on the impact of combined reporting on R&D credit determinations under renumbered Section 3.599(i). The final rule, which was significantly modified from the proposed amendments, clarifies that the combined group is the taxable entity for purposes of combined reporting, and requires the total qualified research expense of each member of the combined group to be added together to determine the total credit claimed on the combined report. In contrast, the proposed amendments would have required each member of a combined group to determine its credit as if it were an individual taxable entity and then add together the total credits for each entity to determine the credit claimed on the combined report.
When the members of a combined group change, the final rule views the resulting combined group as a new taxable entity. The new entity cannot carry forward the R&D credit because it is not the same taxable entity generating the credit carryforward. In contrast, the proposed amendments would have allowed each member of the combined group to claim a portion of the credit carryforward corresponding to the credit generated by that particular member (i.e., the member could still claim the portion of the credit even if it joined a different combined group).11
The final rule applies the rate for qualified research expenses under a higher education contract to the combined group as a whole, even if not all members of the combined group have qualified research expenses. The proposed amendments, in contrast, would have applied the rate for qualified research expenses under a higher education contract to each member of the combined group separately.
If a credit is carried forward, the TX Comptroller may verify that the credit creating the carryforward is based on qualified research activities, even if the statute of limitations has expired for the year of the credit's creation. This verification will not result in a tax adjustment, penalty or interest for any report year for which the statute of limitations has expired but could result in an adjustment to the carryforward for all open and future periods.12
Process of Experimentation Test
The factors in the final rule that may be used to distinguish between experimental and non-experimental trial-and-error methods, for purposes of the Process of Experimentation test, are similar to the criteria listed in the proposed and withdrawn final federal R&D regulations under IRC Section 41. These factors were ultimately rejected in the current final federal regulations because they failed to reflect the manner in which a taxpayer conducts commercial research. One of the factors identified in the final rule (i.e., "whether the person conducting the [trial-and-error] methodology stops testing alternatives once a single acceptable result is found or continues to find multiple acceptable results for comparison") is a good example of a factor that does not reflect commercial research. The factor indicates that a taxpayer should continue to incur costs even if a solution is found, through trial and error, that resolves the taxpayer's uncertainty. None of the examples illustrating the Process of Experimentation Test apply the trial-and-error factors, and it is unclear how the factors help distinguish between "systematic" and "simple" trial-and-error methods.
Internal use software
The definition of internal use software in the final rule essentially excludes from the definition any software that is not intended to directly generate revenue, regardless of whether the software is developed for use by a taxpayer's customers or the general public or for use in the taxpayer's core business activities (e.g., manufacturing, providing services, transaction processing). Under the final rule, a hospital that develops artificial intelligence software to avoid administration of contra-indicated medicines, a manufacturer that develops software to run its robotic machinery or a financial services company that develops software to enable clients to execute transactions online could not treat their software development activities as qualified research. The final rule does not provide any exceptions from the exclusion of internal use software. The federal regulations under IRC Section 41 do not treat software development activities for internal use software as excluded activities if the taxpayer can meet additional requirements. The final rule for Texas franchise tax purposes is significantly more restrictive than the analogous federal rules.
The Four-Part Test for Texas franchise tax R&D credit purposes, as applied to software development, lists only four activities that are likely to be considered qualified research and includes an extensive list of activities that are unlikely to be. Even if the listed activities (such as developing image processing, artificial intelligence, speech recognition or developing an operating system) were considered qualified research, they would ultimately be excluded if they were developed for use in the taxpayer's business and not marketed for separately stated consideration.
The Preamble does not explain why the final rule requires a taxable entity performing research on behalf of another person to identify any other person paying for the research activities and any person with substantial rights to the research. This disclosure is not required for federal income tax purposes under IRC Section 41. The final rule does not indicate whether it applies only if the amounts are determined to be funded (i.e., not contingent on success or the taxpayer performing research does not retain substantial rights) or unfunded (i.e., contingent on success and the taxpayer performing research retains substantial rights), or both. This requirement may be included to facilitate the TX Comptroller's examination of the R&D credit claims of the party for whom the research is being performed.
Contemporaneous business records
The final rule requires "contemporaneous business records" to support all qualified research expenses and defines these records for wages, supplies and contract research. For records destroyed by flood, hurricane, fire or other disaster, or when business units, divisions, subsidiaries or related parties are disposed of between the credit year and the year of examination, the rules requiring maintenance of "contemporaneous business records" do not seem to provide for any relief, even if information about the qualified research expenses could be reliably recreated or estimated by other means.
Burden of proof
The final rule requires "clear and convincing evidence" to meet the burden of proof (the highest standard applicable to civil cases), which is not required for purposes of claiming a research credit under the analogous federal R&D rules.
Several important differences exist between the IRC Section 41 rules and the analogous final Texas R&D rules. These differences could require separate federal and Texas R&D credit calculations, even when all research activities are performed in Texas. This disparity between the applicable federal and Texas R&D rules could increase the complexity and cost to taxpayers for compliance and recordkeeping. Because the TX Comptroller's final rule excludes a large category of software development activities from Texas R&D credit eligibility, taxpayers may wish to consider other states' R&D, location and/or employment credits and incentives regimes when deciding where to perform software development activities.
1 In the Preamble the TX Comptroller said it disagreed with a public comment that the changes to Section 3.599 "are retroactive changes in law," finding them to be "expositions of existing [TX] Comptroller policy" regarding the R&D credit. The TX Comptroller further noted that it "does not view the amendments to this section any differently than the amendments to the Treasury Regulation that are applicable to the 2011 federal income tax year."
2 As noted in the Preamble, the TX Comptroller rejected a number of other public comments, including suggestions that it not redefine "qualified research" and that it eliminate Section 3.599(b)(8)(A)(iii), which excludes from being an in-house research expense a taxable item for which the taxable entity claimed a sales or use tax exemption and the exemption is for use other than in qualified research.
3 New Section 3.599(c)(1)(C).
4 New Section 3.599(c)(1)(D).
5 The concern with Example 8 raised in public comments was that the "example may stand for the proposition that the Process of Experimentation Test requires evaluating multiple alternatives." The TX Comptroller said this was not the intent of the example as such is not required by the IRC.
6 The concern with Example 9 raised in public comments was that the "example may stand for the proposition that the information discovered by a process of experimentation must be completely new to the world." The TX Comptroller said this was not the intent of the example as such is not required by the IRC.
7 New Section 3.599(c)(4)(B) and (C).
8 New Section 3.599(d)(5).
9 New Section 3.599(d)(7)(E).
10 New Section 3.599(e)(3).
11 New Section 3.599(i)(3) lists when no change occurs in the combined group's membership.
12 New Section 3.599(l)(3).